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In re Whitehall Jewellers

February 27, 2006

IN RE WHITEHALL JEWELLERS, INC. SHAREHOLDER DERIVATIVE LITIGATION


The opinion of the court was delivered by: Judge Rebecca R. Pallmeyer

MEMORANDUM OPINION AND ORDER

On February 22, 2005, two shareholders filed this derivative action on behalf of Whitehall Jewellers, Inc., (hereinafter, "Whitehall,") alleging various state and federal law claims against a group of Whitehall's directors. As detailed below, Plaintiffs allege that these directors participated in a rebate scheme that artificially inflated the value of Whitehall's inventory and resulted in a civil suit against Whitehall as well as regulatory and criminal investigations. Eight months before this suit was filed, on June 17, 2004, other Whitehall shareholders filed a similar derivative suit in the Circuit Court of Cook County against the same directors named as defendants here. The Defendant directors named in this suit have moved for the court to stay any further action on this suit until the resolution of that state court suit. For the reasons explained below, the motion for stay is denied.

STATEMENT OF FACTS*fn1

Whitehall, a national retail jeweler, operates nearly 400 jewelry stores in thirty-eight states.*fn2 (Consolidated Amended Derivative Complaint (hereinafter, "CAC,") ¶¶ 10, 45.) Whitehall purchases its inventory from an assortment of vendors. (Id. at ¶ 30.) Derivative Plaintiffs allege that Generally Accepted Accounting Principles (hereinafter, "GAAP,") require the purchaser of inventory to "write down" the value of the inventory from its purchase price to its fair market value as the inventory depreciates. (Id.) Contrary to this requirement, Derivative Plaintiffs allege, the Officer Defendants named in the case*fn3 negotiated an inventory rebate scheme with some of Whitehall's vendors, described more fully below. (Id.)

Chief Financial Officer Browne and Executive Vice Presidents M. Patinkin, Desjardins, and Brown arranged to return depreciated inventory to Whitehall's vendors and "receive excessive discounts, reimbursements, credits, or other 'vendor allowances'" equal to the full average cost at which Whitehall had purchased the inventory. (Id.) In return for these credits, valued far in excess of the fair market value of the returned, depreciated inventory, Whitehall agreed to purchase new, more expensive inventory from the participating vendors. (Id.) The Officer Defendants' failure to adhere to GAAP and their conduct in engaging in this inventory rebate scheme resulted in an inflation of Whitehall's inventory balances and net income on the books. (Id. at ¶ 31.)

Meanwhile, beginning in 2001, one of Whitehall's vendors, Cosmopolitan Gem Corporation (hereinafter, "Cosmopolitan"), had run into financial trouble. (Id. at ¶ 33.) Capital Factors, Inc. (hereinafter, "Capital,") had "made millions of dollars" in loans to Cosmopolitan, secured by Cosmopolitan's accounts receivable. (Id.) When Cosmopolitan sought additional loans from Capital and asked the Officer Defendants to help conceal Cosmopolitan's precarious financial condition from Capital, the Officer Defendants obliged. (Id.) With the Officer Defendants' assistance, Cosmopolitan created fictitious account statements showing receivables owed by Whitehall and payments from Whitehall applied to those receivables, totaling some $13.9 million in the several months prior to March 2002. (Id. at ¶¶ 34, 35.) These machinations created the illusion that Cosmopolitan was collecting its aging receivables, improving that part of Cosmopolitan's books which Capital would examine in deciding whether or not to extend Cosmopolitan additional credit. (Id. at ¶ 34.) Whitehall received discounts, credits, and other vendor allowances on its inventory purchases from Cosmopolitan in exchange for its participation in the scheme.*fn4 (Id.)

At Cosmopolitan's request, Whitehall designated the payments to Cosmopolitan as "on account" rather than for any particular invoice. (Id. at ¶ 35.) At some point (the date is not identified in the complaint), Capital asked Cosmopolitan and Whitehall to provide it with more information regarding the invoices to which Cosmopolitan applied the "on account" payments. (Id. at ¶ 36.) Instead of presenting Capital with any statement showing the large number of deductions and credits Whitehall had received from Cosmopolitan, Whitehall CFO Browne, Cosmopolitan's controlling shareholder Joshua Kestenbaum, and Cosmopolitan Chief Financial Officer Christopher Shaw created and presented a phony statement that did not reflect many of the deductions and credits and showed Whitehall's "on account" payments as being applied to aging Whitehall receivables. (Id. at ¶¶ 37, 38.) Browne, Kestenbaum, and Shaw submitted at least three such phony statements to Capital over the course of several months beginning in April 2002 and ending in September 2002. (Id. at ¶¶ 37, 39.)

Capital seems to have caught on; in August 2003, it brought a $30 million lawsuit against Whitehall and Cosmopolitan, as well as several other defendants, alleging a scheme to defraud Capital by inducing it to advance Cosmopolitan funds by means of misrepresentations concerning Cosmopolitan's financial state. (Id. at ¶¶ 41, 45.) Perhaps tipped off by the civil suit and by a March 5, 2003 Whitehall press release declaring an intention to restate its financial statements for the first three fiscal quarters of 2002,*fn5 the Securities and Exchange Commission (hereinafter, "SEC,") and United States Attorney for the Eastern District of New York initiated an investigation into Whitehall in November 2003. (Id. at ¶¶ 40, 42, 43).

On November 21, 2003, Whitehall issued a press release announcing that its internal investigations had discovered that its Executive Vice President of Merchandising Lynn Eisenheim had violated company policy by failing to document the age of certain inventory. (Id. at ¶¶ 43, 45.) Whitehall asserted that Eisenheim's failures related to less than one percent of Whitehall's total current inventory and that this violation was unrelated to the Capital lawsuit. (Id.) On December 11, 2003, a Whitehall press release announced the termination of Jon H. Browne as Chief Financial Officer and the appointment of Executive Vice President John R. Desjardins to that position. (Id. at ¶ 44.) Following this announcement, Whitehall's stock value fell 75 cents to $9.04, part of a 29 percent decline in value since receiving its SEC subpoena in November. (Id. at ¶ 45.)

On December 22, 2003, Whitehall released its third quarter results for 2003, reporting a $0.53 per share net loss (as compared to $0.35 per share net loss for the same quarter a year earlier) and laying some of the blame on fees related to the Capital lawsuit, the SEC investigation, and the criminal inquiry. (Id. at ¶ 46.) Whitehall also announced that it would be restating its financial reports for 2000, 2001, 2002, and the six-month period ending in July 31, 2003.*fn6 (Id. at ¶¶ 46, 47.) Whitehall's press release explained that "[t]he restatements primarily reflect the Company's revision of the accounting treatment for vendor allowances associated with the Company's return of substandard inventory to vendors." (Id. at ¶ 46.) CFO Desjardins offered further details to analysts and investors during a December 22, 2003 phone call. (Id. at ¶ 47.) As recorded in a transcript of that conference call, Desjardins reported:

The company enjoyed strong ongoing relationships with many of its suppliers. Based upon the strength of those relationships, the company would, from time to time, negotiate separate agreements, distinct from the terms of our standard trading agreements, under which vendors accepted returns of certain substandard inventory, [sic] the full credit of the company's weighted average cost of those items. Generally these returns were accepted by the vendor in conjunction with the placement of purchase orders for fresh inventory. The company did not record a reserve associated with the impairment of substandard inventory. As a result of a reevaluation of the relevant accounting guidelines, Whitehall will now record an impairment charge associated with substandard inventory in each reporting period. Thereafter, as returns of substandard inventory are made, the company will reflect the implicit benefit of the lower inventory cost related to the impairment reserves in its cost of sales over the inventory turnover period associated with the new inventory being purchased from the vendor. (Id. at ¶ 47.) Litigation and investigation costs, running into the millions, continued to affect Whitehall's performance for the next four fiscal quarters. (Id. at ¶¶ 49-52, 55.) On September 28, 2004, Whitehall announced that it had settled the litigation with Capital by paying Capital $10.8 million. (Id. at ¶ 54.) The U.S. Attorney for the Eastern District of New York also agreed not to file charges against Whitehall, on the condition that Whitehall made restitution to Capital and paid $350,000 to the United States. (Id.)

According to Whitehall's proxy statements, the Board of Directors met eleven times during 2002 and 2003. (Id. at ¶ 56.) The Audit Committee, including the Audit Committee Defendants in this case, met twenty-one times during this period. (Id.) Derivative Plaintiffs allege that each director was in attendance at each meeting and had full knowledge of Whitehall's improper business and accounting practices. (Id.) Furthermore, the Officer Defendants received salaries, cash bonuses, shares of Whitehall stock, and options to purchase Whitehall stock based on the inflated financial statements initially issued for fiscal years 2000 through 2003. (Id. at ¶ 59.) The Officer Defendants also sold shares of Whitehall stock to unspecified purchasers at the end of March 2002 and at the beginning of June 2002, at a price which did not reflect their private knowledge that Whitehall was engaged in improper business and accounting practices that would necessitate a restatement of the company's financial statements and lower the share price. (Id. at ¶ 64-65.)

PROCEDURAL HISTORY

Myra Cureton, a California shareholder in Whitehall, filed a complaint in this court on February 22, 2005. Cureton sued derivatively on behalf of nominal defendant Whitehall and named as Defendants M. Patinkin, Desjardins, Brown, Berkowitz, Levy, Shkolnik, and N. Patinkin, as well as Whitehall President Hugh M. Patinkin.*fn7 As originally filed, the Cureton complaint stated a single state law claim for breach of fiduciary duty, invoking the federal court's diversity jurisdiction.

On April 13, 2005, Tai Vu, also a California shareholder in Whitehall, filed a similar state law claim against the same defendants in this court. On May 25, 2005, this court granted a motion for reassignment of the Vu case as related to Cureton. Derivative Plaintiffs filed their consolidated amended derivative complaint on June 20, 2005, sub nom, In re Whitehall Jewellers, Inc. S'holder Derivative Litig. The complaint names M. Patinkin, Desjardins, Brown, Browne, Berkowitz, Levy, Shkolnik, and N. Patinkin as Defendants. In addition to the original breach of fiduciary duty claim against all Defendants, Derivative Plaintiffs charged the Officer Defendants with one count for violation of § 10(b) of the Securities Exchange Act and Rule 10b-5 and two additional state law claims for unjust enrichment and a breach of the fiduciary duty of loyalty in the form of insider trading. The final count was levied against Defendant Browne alone and sought reimbursement for Whitehall pursuant to § 304 of Sarbanes-Oxley Act of 2002, 15 U.S.C. § 7243. This complaint now asserts both diversity and federal question jurisdiction.

On July 15, 2005, Defendants filed this motion to stay proceedings pursuant to the Colorado River Abstention Doctrine. They ask that this court abstain from taking further action on this case pending the outcome of Cusak v. Patinkin, et al., Case No. 04 CH 9705, a shareholder derivative action filed on June 17, 2004, in the Circuit Court of Cook ...


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